After nearly two years of recession, Italy’s economy is showing signs of stabilizing but continues to face strong headwinds from tight credit conditions, according to the IMF’s latest annual check-up. A modest recovery—of about 0.7 percent—is expected to take hold later this year, led by exports.

However, without deeper structural reforms, growth prospects remain weak. “The euro-zone crisis hit Italy hard,” said Kenneth Kang, an assistant director in the IMF’s European Department, “but the seeds of Italy’s low growth pre-date the crisis and stem from its stagnant productivity, difficult business environment, and over-leveraged public sector. Accelerating reforms to address these structural impediments will be essential for securing a robust recovery.”

Structural reforms—Priorities to revive growth

Over the last few years, the authorities have embarked on a wide reaching reform agenda. However, more is still needed to boost productivity and raise employment.

Raising Italy’s low employment, especially of youth and women, is a priority. Closing half the employment gap with the rest of Europe (some 4½ percentage points) could lift the level of GDP by as much as 2½ percent by 2018.

On the labor market, IMF staff proposed improving programs that help people find work, simplifying contracts and decentralizing wage setting. “Currently, local authorities are in charge of job matching and training, which needs better coordination,” explained Sergi Lanau, an economist on the Italy desk, “while wage setting is very centralized and would benefit from more firm-level agreements that better match wages and productivity.”

The IMF’s report also welcomed efforts to improve the efficiency of the civil judicial system. It takes on average more than 1,200 days to enforce a contract in Italy, more than twice the average for advanced economies, so reforms here could have significant cross-cutting benefits for the economy more generally.

Taming government debt—Less spending and lower taxes

The government’s sizeable budget adjustment, which lowered economic growth but was essential for strengthening confidence in Italy’s fiscal position, is slowing in 2013. However, care must be taken to adhere to the fiscal plans. Over the medium term, and once the recovery is underway, the authorities should aim to bring down debt still faster.

Some rebalancing of the budget items would also support growth. “If the government can roll back inefficient public spending and tax expenditures, then these savings could be used to lower taxes on business and labor,” explained Luc Eyraud from the IMF’s Fiscal Affairs Department. “This in turn could help stimulate investment and hiring by firms.” The planned replacement of the property tax with a new local services tax in 2014 should be designed so as to raise revenue in an efficient, equitable and growth friendly way.

Banking sector—strengthening balance sheets and lending

Italian banks were hit hard by the depth of the recession and the financial fragmentation in the Euro-zone. “Banks have strengthened their capital position in the last year, but remain vulnerable to a weak economy. The ratio of non-performing loans has almost tripled since 2007 and is a drag on bank profits,” said Nadege Jassaud, a senior economist from the IMF’s Monetary and Capital Market Department. “The authorities should consider a variety of measures including encouraging further provisioning and write-offs, increasing tax deductibility of loan loss provisions and speeding up judicial processes, to reduce bad debts and support bank credit." Capital and liquidity buffers would support bank lending. The recent financial sector assessment (FSAP) of Italy, looks more in depth at the health of the country’s financial system.

But Italy is not alone. National efforts should be complemented at the euro area level with steps to strengthen the currency union and support growth.

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